JOHANNESBURG – A recent New York Times article penned by Erin Griffith titled “More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost” is a great reminder that throwing money at a problem doesn't solve it.
The Silicon Valley growth in venture capital (VC) has been fuelled by the never-ending chase of the “Unicorn”. As a result, according to the New York Times, entrepreneurs feel that Venture Capital is not the healthiest form of funding for their businesses, and many are seeking alternative forms of funding.
This is a great lesson for the South African investment and entrepreneur ecosystems as we begin seeing signs of growth in VC funding.
The Southern Africa Venture Capital and Private Equity Association estimates that R1 billion was invested in start-ups last year.
Compared to the nearly $100 billion (R1.36 trillion) in VC funding in the US, South Africa has a long way to go before experiencing the challenges faced there, especially considering that only 20 percent of start-ups managed to raise Angel or VC funding in South Africa (according to a Ventureburn survey).
But perhaps this is a prudent approach and self-funding or bootstrapping is a healthier way to go, that is, if the US is anything to go by.
Venture capital certainly has its place, and it is difficult to disregard a model that has some of the most valuable companies today.
However, this is a great time to re-look at the mechanics and incentives of the sector that are driving the push-back, and draw lessons for the evolution of VC at home.
There are three primary players in VC:
- The investor.
- The fund manager.
- The entrepreneur.
It is easy to see how each party walks away happy in a positive scenario – everyone makes money. In the event that something goes wrong, who loses?
The investor loses his/her cash, and the entrepreneur loses their livelihood. But what of the fund manager? This is one business in a portfolio of companies for the fund manager and, hopefully, the other companies can make up for that loss.
However, the fund manager continues to draw a management fee, based on total funds under management and continues to invest. Little, if anything, changes for the fund manager.
The risks in the current model appear distorted. And perhaps that is the disdain entrepreneurs are feeling for the current set up.
An alternative to the current model is for fund managers to be incentivised on a deal-by-deal basis where they earn their carry points on successful deals, but pay them back on unsuccessful ones.
Or for management fees to be based on different metrics (to prevent over-raising and thus over-investing capital), it's hard to say what that could be, but there are myriad models, each with its own nuisance – maybe base fees on sweat equity, or pay fees in direct equity.
Or to structure as a holding company, and have a longer-term view of investments that avoid the pump and dump we're currently seeing.
The excess of capital seems to be a large driver in chasing an ever-shrinking pool of potential investments.
Undoubtedly, any change or tweak will have unintended consequences, but if this is a big enough issue for the majority of entrepreneurs then it certainly is worth solving, even if for the financial upside of being first to market with an alternative and more efficient VC model.
Whatever the new model is, or whatever version of funding entrepreneurs seek, there needs to be an alignment of incentives with all parties (and by proxy, risks).
Rushil Vallabh is co-founder and managing director of Secha Capital, an impact investing firm aiming to create jobs by investing in SMEs. He is also a contributing writer for AfricanTechRoundup.com. Follow Rushil on Twitter @Rushil_Vallabh. The views expressed here are his own.